At present I current two classes.  First, we be taught why diabetes will not be a per se incapacity adequate to keep away from penalties for early 401(ok) distributions.  Second, we be taught that professional se litigants can not depend on the Tax Court docket to contemplate potential arguments they may have raised, however didn’t.

Diabetes is a well known and widespread illness, afflicting some 37.3 million folks within the U.S., in accordance with the CDC’s 2022 Nationwide Diabetes Statistics Report.  That’s simply over 11% of the US inhabitants.  Medical problems abound, as detailed in this report from the Diabetes Institute Analysis Basis.

Managing diabetes and its attendant problems will be tough and costly.  In recognition of that, Canada provides this tax credit score to Canadians who should handle the illness.  And within the U.S., lots of the prices related to diabetes qualify for the medical expense deduction underneath §213.  See e.g. IRS Publication 502 (2021) at p. 7 (explaining that price of blood sugar take a look at package for diabetes is a qualifying medical expense).

In Robert B. Lucas v. Commissioner, T.C. Memo. 2023-9 (Jan. 17, 2023) (Choose Urda), the unemployed taxpayer took an early distribution from his 401(ok) plan to assist make ends meet, which included serving to to handle his diabetes.  The difficulty was whether or not he needed to pay the §72(t) 10% penalty for early distributions.  He may keep away from your entire penalty if his diabetes certified as a incapacity, and he may keep away from a few of it if the distribution was used for bills allowable as a §213 deduction.  As to the primary, Choose Urda teaches us why diabetes will not be, in and of itself, a incapacity adequate to flee the ten% penalty.  As to the second, Choose Urda notes the difficulty however, as a result of the taxpayer didn’t elevate it, “[w]e accordingly deem the difficulty forfeited.”  Op. at 4.  In doing that, Choose Urda teaches an necessary lesson on the position of the Tax Court docket.

Particulars under the fold.

Legislation: The Sizzling Mess of §72(t) Penalties
In 1978, Congress enabled the fashionable outlined contribution plans by creating a brand new subsection (ok) in §401.  Income Act of 1978, Pub.L. 95–600, 92 Stat. 2763.  You could find a pleasant quick historical past of §401(ok) and its sudden penalties in this CNBC article from 2017.

In 1986 Congress created §72(t) as a type of penalty hub for early distributions from any kind of retirement plan.  Tax Reform Act of 1986 P.L. 99-514, 100 Stat. 2085, 2472.  Part 72(t) is now the go-to place to determine early distribution penalties for every type of retirement accounts, together with 401(ok) plans and the varied flavors of IRAs.

Sure, sure, all you fussbudgets, I do know the Tax Court docket doesn’t view §72(t) as a penalty however as a substitute as a tax.  El v. Commissioner, 144 T.C. 140 (2015) (§72(t), imposes a “tax” and never a “penalty, addition to tax, or further quantity” for functions of burden of proof shifting guidelines in §7491(c)).  However widespread understanding is completely different, as you see from this rationalization from funding mega-firm Constancy! So with out moving into the metaphysical dialogue of the excellence between a “tax” and a “penalty” I’m going to stay with the widespread parlance. Word: even Choose Urda slips up and calls it a penalty.  See Op. at p. 3.

Name it a tax, name it a penalty, name it a banana, the final rule in §72(t)(1) is now because it has been since 1986: taxpayers should pay an additional 10% on any distribution from “a certified retirement plan (as outlined in part 4974(c)).”  That features §401(ok) plans.

Part 72(t)(2) then provides an ever-expanding and complicated bunch of exceptions to the ten% penalty.  For a lesson on one of many large confusions that journey up taxpayers, see Lesson From The Tax Court docket: Know The Distinction Between IRAs And 401(ok)s, TaxProf Weblog (Aug. 12, 2019).

The principle exception to the penalty is, after all, for distributions “made on or after the date on which the worker attains age 59½.”  §72(t)(2)(A)(i).  Please don’t ask me why the half-year issues.  Maybe some educated reader can inform us why within the feedback?

Due to this fact, taxpayers who take what we name “early” or “untimely” distributions (earlier than the sixth month after their 59th birthday) should discover refuge from the penalty in one of many different myriad exceptions in §72(t).  Two of these are related to immediately’s classes.

First is the incapacity exception.  Subsection (t)(2)(A)(ii) says there isn’t any penalty for distributions “attributable to the worker’s being disabled inside the that means of subsection (m)(7).”  Subsection (m)(7), titled “Which means of Disabled” says that an worker is disabled when “unable to interact in any substantial gainful exercise by cause of any medically determinable bodily or psychological impairment which will be anticipated to end in loss of life or to be of long-continued and indefinite length.”

The laws create a facts-and-circumstances take a look at for the (m)(7) incapacity dedication.  The take a look at consists of the character and severity of the impairment, the taxpayer’s schooling, coaching, and work expertise.  Most significantly, the laws make clear what the requirement is not.  It isn’t that the taxpayer can not have interaction in any kind of paid work.  Relatively, the impairment should forestall the taxpayer from working within the similar type of job the taxpayer was engaged in earlier than the impairment.  See Treas. Reg. 1.72-17A(f)(1) (“The substantial gainful exercise to which part 72(m)(7) refers is the exercise, or a comparable exercise, by which the person typically engaged previous to the arising of the incapacity or previous to retirement if the person was retired on the time the incapacity arose.”).  The regulation provides the next examples of “impairments which might ordinarily be thought of as stopping substantial gainful exercise…(ii) Sure progressive ailments which have resulted within the bodily loss or atrophy of a limb, equivalent to diabetes, a number of sclerosis…”  However it should all the time be a facts-and-circumstances take a look at.

Second is the medical expense exception.  Subsection (t)(2)(B) says the ten% penalty won’t apply to distributions that “don’t exceed the quantity allowable as a deduction underneath part 213 to the worker for quantities paid throughout the taxable yr for medical care (decided with out regard as to whether the worker itemizes deductions for such taxable yr).” I’m not effectively versed on this nevertheless it seems to me that this rule applies whether or not or not the taxpayer has claimed these bills as an itemized deduction.  That’s, say the taxpayer takes an early distribution of $10,000 and in addition spends $10,000 on medical bills that qualify for the §213 deduction.  However the taxpayer additionally has an AGI of $100,000 and so solely $2,500 of these medical bills are literally allowable deductions.  See §213(a) (imposing 7.5% ground).  I learn §72(t)(2)(B) as excluding $2,500 of the early withdrawal from the ten% penalty, no matter whether or not the taxpayer truly itemizes that $2,500.  That’s as a result of cash is fungible and I discover no tracing requirement.  Sadly, I actually can not discover any authority supporting or negating that understanding so I welcome any feedback from extra educated readers correcting my understanding!

Info
The yr at problem is 2017 however the related information return to 2015.  At the moment Mr. Lucas was a software program engineer and through that yr he was recognized with diabetes.  He was capable of proceed working, nonetheless, “successfully treating his diabetes with a mixture of insulin shorts and different drugs.”  Op. at 5.  He continued to work as a software program engineer till 2017 when he was laid off.  Throughout that yr, “to make ends meet, he obtained a distribution of $19,365…from a bit 401(ok) plan account.”  Op. at 2.  His 401(ok) administrator despatched the IRS a Kind 1099-R reporting the distribution and reporting it as one being an early distribution with no identified exceptions to being taxable.

Whereas Mr. Lucas disclosed the distribution on his 2017 tax return, he didn’t (a) report any a part of the $19k as gross revenue, or (b) calculate and pay the ten% penalty.

That’s to its pc matching program, the IRS picked up the error and despatched Mr. Lucas an NOD asserting a complete deficiency of about $5,000.  It doesn’t seem the IRS asserted a §6662(a) penalty.

Lesson 1: Diabetes Not a Per Se Incapacity for §72(t) Exceptions
In Tax Court docket Mr. Lucas represented himself.  That’s comprehensible as a result of the quantity in controversy was solely about $5,000.  I might guess it might price him at the very least half of that to get illustration however I’m simply an instructional so what do I find out about charges?  I welcome feedback on that.

You would inform that Mr. Lucas was confused about some primary points.  For instance, in attempting to clarify why he thought he may exclude your entire early distribution from gross revenue, Mr. Lucas pointed to an internet site he had relied on for recommendation.  Choose Urda needed to clarify that the web site was simply addressing “the applicability of the early withdrawal penalty in instances of incapacity.”  Op. at p. 3 (Emphasis provided and never merely to level out that Choose Urda additionally calls the §72(t) quantity a “penalty”!).  The applicability of the additional 10% “is a definite topic from whether or not the distribution counts as revenue” within the first place, explains the Choose.  Id.  The early distribution was revenue as a result of, as we noticed in this yr’s first Lesson, the whole lot is revenue.

Choose Urda then turned to the query of whether or not Mr. Lucas was disabled in 2017 due to his diabetes.  Recall this can be a facts-and-circumstances take a look at on whether or not the impairment prevents the taxpayer from partaking is the similar type of job he had been doing.  Though the regulation lists diabetes as a potential impairment, whether or not it’s truly an impairment simply….relies upon.  On this case, Choose Urda discovered that since Mr. Lucas was capable of be gainfully employed as a software program engineer after his diabetes diagnoses in 2015, he was not disabled for functions of this exception.  It was necessary to Choose Urda that Mr. Lucas was profitable in managing his illness.  See Op. at p. 2, p. (he had “successfully … handled” it); p. 5 (similar).

Backside line: When evaluating the applicability of the §71(t) 10% penalty, the query will not be whether or not a consumer has diabetes (or some other illness), the questions are (a) how managed is it and (b) does it forestall the taxpayer from partaking of their regular kind of labor?

Lesson 2: Don’t Depend on The Tax Court docket to Assist You
Mr. Lucas was not solely confused about primary concepts of revenue, he additionally seems to have completely missed the medical expense exception to the §71(t) penalty.  That’s, treating his diabetes was not costless.  Mr. Lucas may keep away from the ten% penalty on no matter quantity of his early distribution matched his diabetes bills.  §71(t)(2)(B).  I am no knowledgeable on this however I didn’t discover any tracing requirement.  That will make sense as a result of cash is fungible.

In line with this American Diabetes Affiliation webpage, people with diabetes spend about $16,000 per yr managing it. Assume Mr. Lucas spent that quantity in 2017.  Assume his AGI was $100k.  In that case I feel §71(t)(2)(B) would exclude $9,500 ($16,000 – $7,500) from the penalty whether or not or not he additionally deducted that quantity as a part of itemizing.  Not less than that’s my admittedly neophyte studying of that provision.

Choose Urda notes this risk in footnote 3 of the opinion.  However he refuses to contemplate it as a result of Mr. Lucas—continuing professional se keep in mind—“didn’t declare he certified for it.”  Op. at 4 (word 3).

One certainly can not fault Choose Urda for this strategy.  Tax Court docket litigation is—as a proper matter— an adversarial course of and the hallmark of adversarial course of is that every social gathering is accountable for its personal arguments.  The Court docket exists to referee and decide the deserves of the arguments either side raises.  In an adversarial system it’s merely not the job of the Court docket to transcend the arguments raised by the events.

That stated, Tax Court docket judges do typically take a extra inquisitorial strategy.  That’s, no matter what the events argue, the Tax Court docket will typically train discretion to look extra carefully at a difficulty, as a part of its job to “redetermine.”  Two latest instances illustrate my level.

First, in Patacsil v. Commissioner, T.C. Memo. 2023-8 (Jan. 17, 2023), Choose Holmes went past arguments raised by the taxpayers to behave on data within the file.  In that case, the NOD asserted a deficiency based mostly, partly, on unreported revenue of $7,000 from the Discharge of Indebtedness (DOI).  The professional-se taxpayers argued they have been bancrupt within the yr of the DOI however couldn’t show it.  The professional-se taxpayers didn’t elevate any argument in regards to the sufficiency of the NOD.  Nonetheless, Choose Holmes took a really shut have a look at the info within the file to conclude that “a transcript of all of the third-party experiences of revenue” offered by the IRS didn’t replicate any Kind 1099 for the DOI for the yr at problem.  Op. at 9.  Accordingly, Choose Holmes determined that a part of the NOD was faulty.  However this was not due to any argument the taxpayers made; it was as a result of the Tax Court docket Choose made his personal deep dive inquiry past the face of the NOD.

Second, in Belton v. Commissioner, T.C. Memo. 2023-13 (Jan. 24, 2023), Choose Toro additionally went past arguments raised by the taxpayers to behave on data within the file.  There, the IRS had licensed the taxpayers to the Division of State as having “severely delinquent tax debt” as a part of the passport revocation process.  For an outline of the passport revocation course of see Lesson From The Tax Court docket: Cheshire Cat Jurisdiction Over Passport Revocation Petitions, TaxProf Weblog (June 29, 2020).

One problem in Belton was whether or not the taxpayers—once more continuing professional se—had a “severely delinquent tax debt” on the time the IRS made the certification.  To indicate they did, the IRS produced a transcript of the taxpayers’ account, exhibiting the varied occasions that occurred.  The taxpayers appeared to make no argument in regards to the validity of the account transcript.  I imply, come on.  Why on earth would you count on a pro-se taxpayer to know how you can learn a transcript or to even know there are completely different varieties of transcripts?

Choose Toro made a cautious inquisition into the transcripts—unbiased of any taxpayer argument.  He learn them critically to conclude that “the Belton’s…transcript and literal account transcript include entries that elevate questions in regards to the validity” of the quantity licensed to the State Division.  Op. at 22.  Whereas that doesn’t finish the case—Choose Toro was merely denied the IRS movement for Abstract Judgment—it does present that typically the Tax Court docket sees its job as greater than only a passive receptor of arguments from the events—the quintessential position of a Court docket in an adversarial system.  Generally the Tax Court docket will take a extra energetic position, performing as a Court docket of Inquisition to make sure a correct consequence.

However you can’t depend on it.

Backside Line:  alert readers will see distinctions between immediately’s case and the 2 I simply talked about and we may have a stunning dialogue about simply when and the way the Tax Court docket would possibly depart from a strictly adversarial mannequin of judging.  For immediately’s functions, nonetheless, I simply wished to alert readers that you just can not count on the Tax Court docket to rescue you from arguments or points that you could be miss. 

Bryan Camp is the George H. Mahon Professor of Legislation at Texas Tech College College of Legislation.  He invitations readers to return every Monday (or Tuesday if Monday is a federal vacation) to TaxProf weblog for one more Lesson From The Tax Court docket.

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